Chapter 01 – Introduction to Corporate Finance

Chapter 1 Introduction to Corporate Finance

OVERVIEW

The opening chapter provides the students with an overview of the field of finance and a brief
overview of the book. The chapter briefly explains the role of corporations, financial managers
and financial markets in the financial decision making process. The success of any firm in
financial management is measured by the increase in the increase in the value of the firm. The
financial decisions made by firms are generally geared towards this objective. Generally, there
are two types of financial decisions that are made in a corporation: investment decisions and
financing decisions. In order to make these decisions a financial manager not only uses input
from the corporation, but also from financial markets. Related topics, such as different types of
corporations, the role of the financial manager, and the importance of well-functioning financial
markets in the financial decision making process, are discussed.

LEARNING OBJECTIVES

 Understand the definition of a corporation and how finance fits into the corporate
structure.
 The role of the financial manager in a corporation.
 Functions of financial markets.
 Principal-agent problems, agency costs and information asymmetries.

Corporate investment and financing decisions

The primary components of the entire book are presented. These include investment and
financing decisions. Both are presented under the umbrella the corporation. It is important to
emphasize that these two concepts are driving the book. That message can be lost and must be
reinforced from the beginning. The emphasis on the corporation is also important, since students
sometimes deviate into business structures that are not necessarily the core focus of the book.

Financial decision making has six steps

1. Define objective(s).
2. Identify possible courses of action.
3. Assemble data relevant to the decision.
4. Assess the data and reach a decision.
5. Implement the decision.
6. Monitor the effects of the decision.

Elements of a decision
a) An objective that can be quantified Sometimes referred to as 'choice criterion' or
'objective function', e.g. maximisation of profit or minimisation of total costs.

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Chapter 01 – Introduction to Corporate Finance

b) Constraints Many decision problems have one or more constraints, e.g. limited raw materials,
labour, etc. It is therefore common to find an objective that will maximise profits subject to
defined constraints.
c) A range of alternative courses of action under consideration. For example, in order to
minimise costs of a manufacturing operation, the available alternatives may be:
i) to continue manufacturing as at present
ii) to change the manufacturing method
iii) to sub-contract the work to a third party.
d) Forecasting of the incremental costs and benefits of each alternative course of action.
e) Application of the decision criteria or objective function, e.g. the calculation of expected
profit or contribution, and the ranking of alternatives.
f) Choice of preferred alternatives.

The role of the financial manager and the opportunity cost of capital

The financial manager is pictured as an intermediary between capital markets and the firm’s
operations, responsible both for financing decisions (decisions that involve raising money) and
investment decisions (decisions that involve spending money). The financial manager must
understand how risky, long-lived assets are valued in order to make decisions that benefit the
shareholders/owners. They also must understand the functions of financial markets. Financial
markets provide a source of financing for corporations. Financial markets provide liquidity for
investors by providing a place to trade securities. An important emphasis in this section is the
opportunity cost of capital. Students often know of this phrase from an economics course, but
rarely understand the component of risk that is attached to opportunity cost. This is the place
where an emphasis on risk return trade-offs should begin.

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Chapter 01 – Introduction to Corporate Finance

Goals of the corporation

Value maximization is presented as a traditional concept. It is immediately modified to

incorporate modern thought on the topic. This expands the goal from simply value maximization
to include other components, such as ethics and stakeholders. The section does not attempt to
define the goal of the corporation as etched in stone. Given the graduate nature of the text, the
topic is presented in a Socratic method and the student is left to ponder the issues raised by
ethics, stakeholders and other issues which impact value creation

. Business objectives
• Various possibilities suggested: for example, maximisation of profit.
• Maximisation of shareholders’ wealth is generally accepted as the key objective because
it takes account of returns and risk and provides a practical measure.
• Maximisation of shareholders’ wealth can be seen as an objective which tends to promote
the interests of all stakeholders (customers, employees, suppliers etc.).
• Maximisation of shareholders’ wealth seems to be the objective followed by most larger
businesses.
• Survival : Most business would see survival as a minimum objective to pursue
• Long term stability
• Growth of profits

Short-termism
• This is excessive focus on short-term results at the expense of long-term interests.
• Such strategies are based on accounting driven metrics (eg EPS ) and profit
maximization. In fact the root cause of the economic downturn was due to the short-
termism of the financial institutions. Their immediate objective was to make profit
without taking long term planning into consideration.
• Managers might promote short-term profits for the following reasons.
a) The managers’ remuneration are linked to the business’ share price, the higher the
share price , the bigger the bonus awarded.
b) A weak price share price is might encourage takeover of the business.

Agency problems and corporate governance

The separation of ownership and management is an important characteristic of the corporation.

In the ideal case, this enables the managers to make decisions without worrying about owners’
preferences. It has its share of advantages and disadvantages. This gives rise to principal-agent
problems and agency costs. These concepts are discussed in this section. Information
asymmetries are major barriers to resolving principal-agent problems facing corporations. The
topic of corporate governance is introduced and should be supplemented by current events. The
mortgage crisis is noted as one such example.

Agency problems

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Chapter 01 – Introduction to Corporate Finance

• Conflicts of interest between shareholders and directors.

• Can lead to costs for shareholders, either the costs of prevention or the cost of directors
having acted counter to the best interests of shareholders.
• Arise in various contexts in business finance, for example making investments that are
not in the best interests of shareholders, though they may be beneficial for the directors.

Relevant costs for decision making

The costs which should be used for decision making are often referred to as "relevant costs".
CIMA defines relevant costs as 'costs appropriate to aiding the making of specific management
decisions'.
To affect a decision a cost must be:
a) Future: Past costs are irrelevant, as we cannot affect them by current decisions and they are
common to all alternatives that we may choose.
b) Incremental: ' Meaning, expenditure which will be incurred or avoided as a result of making a
decision. Any costs which would be incurred whether or not the decision is made are not said to
be incremental to the decision.
c) Cash flow: Expenses such as depreciation are not cash flows and are therefore not relevant.
Similarly, the book value of existing equipment is irrelevant, but the disposal value is relevant.
Other terms:
d) Common costs: Costs which will be identical for all alternatives are irrelevant, e.g. rent or
rates on a factory would be incurred whatever products are produced.
e) Sunk costs: Another name for past costs, which are always irrelevant, e.g. dedicated fixed
assets, development costs already incurred.
f) Committed costs: A future cash outflow that will be incurred anyway, whatever decision is
taken now, e.g. contracts already entered into which cannot be altered.

The assumptions in relevant costing

Some of the assumptions made in relevant costing are as follows:

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Chapter 01 – Introduction to Corporate Finance

a) Cost behaviour patterns are known, e.g. if a department closes down, the attributable fixed
cost savings would be known.
b) The amount of fixed costs, unit variable costs, sales price and sales demand are known with
certainty.
c) The objective of decision making in the short run is to maximise 'satisfaction', which is often
known as 'short-term profit'.
d) The information on which a decision is based is complete and reliable.

Sunk Costs
All costs incurred in the past that cannot be changed by any decision made now or in the
future.Sunk costs should not be considered in decisions.
Example: You bought an automobile that cost $12,000 two years ago. The $12,000 cost is sunk
because whether you drive it, park it, trade it, or sell it, you cannot change the $12,000 cost

Corporate governance refers to the system by which corporations are directed and managed. It
influences how the objectives of the company are set and achieved, how risk is monitored and
assessed, and how performance is optimized. Good corporate governance structure encourage
companies to create value (through enter entrepreneurialism, innovation, development and
exploration) and provide accountability and control systems commensurate with the risks
involved.
The governance structure should specify the distribution of rights and responsibilities among
different participants in the corporation (such as the board of directors, managers, shareholders,
creditors, auditors, regulators, and other stakeholders) and specifies the rules and procedures for
making decisions in corporate affairs. Governance provides the structure through which
corporations set and pursue their objectives, while reflecting the context of the social, regulatory
and market environment. Governance is a mechanism for monitoring the actions, policies and
decisions of corporations. Governance involves the alignment of interests among the
stakeholders.[
There has been renewed interest in the corporate governance practices of modern corporations,
particularly in relation to accountability, since the high-profile collapses of a number of large
corporations during 2001-2002, most of which involved accounting fraud. Corporate scandals of
various forms have maintained public and political interest in the regulation of corporate
governance. In the U.S., these include Enron Corporation and MCI Inc. (formerly WorldCom).
Their demise is associated with the U.S. federal government passing the Sarbanes-Oxley Act in
2002, intending to restore public confidence in corporate governance. Comparable failures in
Australia (HIH, One.Tel) are associated with the eventual passage of the CLERP 9 reforms.

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Chapter 01 – Introduction to Corporate Finance

Similar corporate failures in other countries stimulated increased regulatory interest (e.g.,
Parmalat in Italy)
In Singapore , the Code of Corporate Governance (the "Code") came under the purview of MAS
and SGX with effect from 1 September 2007 (http://mas.gov.sg)
Contemporary discussions of corporate governance tend to refer to principles raised in three
documents released since 1990: The Cadbury Report (UK, 1992), the Principles of Corporate
Governance (OECD, 1998 and 2004), the Sarbanes-Oxley Act of 2002 (US, 2002). The Cadbury
and OECD reports present general principles around which businesses are expected to operate to
assure proper governance. The Sarbanes-Oxley Act, informally referred to as Sarbox or Sox, is
an attempt by the federal government in the United States to legislate several of the principles
recommended in the Cadbury and OECD reports.
 Rights and equitable treatment of shareholders: Organizations should respect the
rights of shareholders and help shareholders to exercise those rights. They can help
shareholders exercise their rights by openly and effectively communicating information
and by encouraging shareholders to participate in general meetings.
 Interests of other stakeholders .Organizations should recognize that they have legal,
contractual, social, and market driven obligations to non-shareholder stakeholders,
including employees, investors, creditors, suppliers, local communities, customers, and
policy makers.
 Role and responsibilities of the board: The board needs sufficient relevant skills and
understanding to review and challenge management performance. It also needs adequate
size and appropriate levels of independence and commitment
 Integrity and ethical behavior. :Integrity should be a fundamental requirement in
choosing corporate officers and board members. Organizations should develop a code of
conduct for their directors and executives that promotes ethical and responsible decision
making.
 Disclosure and transparency: Organizations should clarify and make publicly known
the roles and responsibilities of board and management to provide stakeholders with a
level of accountability. They should also implement procedures to independently verify
and safeguard the integrity of the company's financial reporting. Disclosure of material
matters concerning the organization should be timely and balanced to ensure that all
investors have access to clear, factual information

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Chapter 01 – Introduction to Corporate Finance

CHALLENGE AREAS
 Financing and Investing
 Corporate governance
 Agency costs
 Opportunity cost

ADDITIONAL REFERENCES
Allen, Franklin, James McAndrews, and Philip Strahan. “E-Finance: An Introduction” Working Paper 01-
36, Financial Institutions Center, The Wharton School, University of Pennsylvania. October 2001.

Core, J.E., W.R. Guay, and D.F. Larcker. “Executive Equity Compensation and Incentives: A Survey,”
Federal Reserve Bank of New York Economic Policy Review, 9 (April 2003), pp. 27-50.

Gompers, P.A., J.L. Ishii, and A. Metrick. “Corporate Governance and Equity Prices” Quarterly Journal
of Economics, 118(1), February 2003, pp. 107-155.

L. Guiso, L. Zingales, and P. Sapienza, “Trusting the Stock Market,” Journal of Finance 63 (December
2008), pp. 2557–600.

Mackie-Mason, J.K., and R.H. Gordon. “How Much Do Taxes Discourage Incorporation?” Journal of
Finance, (June 1997).

Rappaport, A. “New thinking on how to link executive pay with performance.” Harvard Business
Review, March-April 1999, 91-104.

WEB LINKS
www.mcgraw-hill.co.uk/textbooks/brealey
www.corpgov.net
www.thecorporatelibrary.com
www.riskmetrics.com
www.microsoft.com
www.sony.net
www.nestle.com
www.ge.com
www.ft.com
www.economist.com
www.businessweek.com
www.forbes.com
www.fortune.com/fortune
www.cfo.com

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Chapter 01 – Introduction to Corporate Finance

ADDITIONAL INTERNET ACTIVITIES

Visit
http://finance.wharton.upenn.edu/~allenf/download/Vita/e-finance.pdf
Read the article “E-Finance: An Introduction.”

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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.